BEHAVIORAL LAW AND ECONOMICS,
PATERNALISM, AND CONSUMER
CONTRACTS:
AN EMPIRICAL PERSPECTIVE
Joshua D. Wright*♠
Abstract
Modern legal scholars frequently and increasingly base their analyses on the assumption, grounded largely in the extensive experimental literature, that individuals are subject to a number of systematic behavioral biases. Within the legal literature, behavioral
economic analysis has been relied upon to generate a significant
number of proposals for paternalistic regulation. These proposals
are frequently accompanied by claims that neoclassical economics is
insufficiently flexible to deal with these empirical observations, and
that behavioral law and economics is as a superior guide for policy
analysis. These claims must ultimately be resolved empirically and
turn on whether incorporating insights from behavioral economics
improves our ability to explain the law, understand the behavior of
economic agents, or predict the consequences of legal change. This
* Assistant Professor, George Mason University School of Law. I thank Oren Bar-Gill,
Terrance Chorvat, Jon Klick, Bruce Kobayashi, Russell Korobkin, Victor Fleischer,
Robert Lawless, Kate Litvak, Geoff Manne, Greg Mitchell, Kathy Zeiler, and Todd
Zywicki for comments on earlier drafts. I am grateful to Brandy Wagstaff for research assistance and the NYU Journal of Law and Liberty staff for excellent editorial
comments and suggestions. All errors are my own.
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paper focuses on the shared interest of both neoclassical and behavioral economists in empiricism and explanatory power. It asks
whether behavioral economic analysis of law has increased our
knowledge in an area of “consumer contracts.” Specifically, the
paper surveys the available empirical evidence to assess claims
from the behavioral law and economics literature involving exploitation of consumer biases with credit cards, standard form contracts, and shelf space contracts. I find that the empirical studies of
firm and consumer behavior in these examples do not support the
claims that behavioral law and economics generates greater predictive power than conventional price theory.
I. Introduction
Modern legal scholars frequently and increasingly base
their analyses not on neoclassical economics’ assumption of rationality, but on the assumption that individuals are subject to a number of systematic behavioral biases. This assumption is itself
grounded largely in a substantial experimental literature documenting bounded rationality, errors in judgment, and non-standard
preferences.1 Although some scholars have challenged this empirical literature,2 they have not generally denied the existence of cogni-
For a summary of this literature, see Christine Jolls, Cass R. Sunstein & Richard
Thaler, A Behavioral Approach to Law and Economics, 50 STAN. L. REV. 1471 (1998); Russell B. Korobkin & Thomas S. Ulen, Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics, 88 CAL. L. REV. 1051 (2000).
2 See, e.g., Richard A. Posner, Rational Choice, Behavioral Economics, and the Law, 50
STAN. L. REV. 1551 (1998) (arguing that apparently irrational behavior is, upon
deeper inspection, ultimately rational); John A. List, Neoclassical Theory Versus Prospect Theory: Evidence From the Marketplace, 72 ECONOMETRICA 615 (2004) (arguing that
laboratory results are not robust to market interactions where competition, expertise,
and learning might be expected to ameliorate these biases); John A. List, Does Market
Experience Eliminate Market Anomalies?, 118 Q.J. ECON. 41 (2003) (same); Michael S.
Haigh & John A. List, Do Professional Traders Exhibit Myopic Loss Aversion? An Experimental Analysis, 60 J. FIN. 523 (2005) (same); John A. List & Uri Gneezy, Putting Behavioral Economics to Work: Testing for Gift Exchange in Labor Markets Using Field Experiments (Nat’l Bureau of Econ. Research, Working Paper No. 12063, 2006) (same);
Charles R. Plott & Kathryn Zeiler, The Willingness to Pay-Willingness to Accept Gap, the
“Endowment Effect,” Subject Misconceptions and Experimental Procedures for Eliciting
1
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tive biases, or the possibility that behavioral models might have
greater predictive power than neoclassical models under some conditions.
Legal scholars relying on this literature have overwhelmingly concluded that the presence of such cognitive errors favors
paternalistic intervention. As one leading academic notes, “virtually
every scholar who has written on the application of psychological
research on judgment and choice to law has concluded that cognitive psychology supports institutional constraint on individual
choice.”3 Within the legal literature, behavioral law and economics
scholars also claim that the tools of neoclassical economics are insufficiently flexible to deal with these new empirical observations,
though the history of the evolution of neoclassical economics suggests otherwise.4 Nevertheless, some scholars have been less san-
Valuations, 95 AM. ECON. REV. 530 (2005) (finding that the existence and magnitude of
the “endowment effect” to be a function of experimental procedures and subject
misconception rather than individual preferences); Elizabeth Hoffman, Kevin
McCabe, Keith Shachat & Vernon Smith, Preferences, Property Rights, and Anonymity
in Bargaining Games, 7 GAMES & ECON. BEHAV. 346 (1994) (arguing that experimental
results themselves are the product of experimental procedures and subject misconception rather than individual preferences).
3 Jeffrey J. Rachlinksi, The Uncertain Psychological Case for Paternalism, 97 NW. U. L.
REV. 1165, 1166 (2003). Prominent examples of this type of argument include: Richard H. Thaler & Cass R. Sunstein, Libertarian Paternalism, 93 AM. ECON. REV. 175
(2003); Jolls, Sunstein & Thaler, supra note 1, at 1541; Colin Camerer, et al., Regulation
for Conservatives: Behavioral Economics and the Case for “Asymmetric Paternalism,” 151
U. PA. L. REV. 1211 (2003).
4 Neoclassical economics has responded to a series of challenges based on the desire
to “update” its application to real world observations. For example, neoclassical
economics has adjusted to the reality that firms in real world markets face downward sloping demand curves, and to claims that competitive dynamics between
small numbers of firms involved interdependencies and strategic interaction far
different than predicted by the neoclassical approach. From these adjustments came
the birth of transactions cost economics, industrial organization, a theory of oligopoly, the economic analysis of information and search costs, and other contributions
now considered standard price theory. Henry Manne recently made this point at a
symposium on the implications of the behavioral finance literature, noting that:
“[e]conomists should have no difficulty integrating the useful findings of the psychologists into this newer understanding of how markets function, and I suspect that
behavioral finance will end up as an important sub-field of the theory of price forma-
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guine about the support that behavioral economics lends to the case
for paternalism, arguing that a more complete analysis of the longrun costs and benefits of paternalistic regulations suggests a much
more limited role for government intervention.5 They have emphasized the costs of paternalistic proposals, for example, paternalistic
regulations may lessen the incentive to engage in learning and the
development of rational behavior or exacerbate irrational behavior
by introducing moral hazard.6
While economic analysis of the law certainly is capable of
incorporating the insights of behavioral economics, the question is
whether such a move would be desirable. This is largely an empirical question that turns on whether incorporating the insights from
behavioral economics improves the ability of economics to explain
tion.” Henry Manne, Remarks on the Lewis & Clark Law School Business Law Forum:
Behavioral Analysis of Corporate Law: Instruction or Distraction?, 10 LEWIS & CLARK L.
REV. 169, 176 (2006).
5 See, e.g., Jeffrey J. Rachlinski, Cognitive Errors, Individual Differences, and Paternalism,
73 U. CHI. L. REV. 207 (2006); Richard A. Epstein, Behavioral Economics: Human Errors
and Market Corrections, 73 U. CHI. L. REV. 111 (2006) (discussing the heterogeneity of
cognitive biases and illustrating costs of over-regulation in the context of credit card
borrowing); Edward L. Glaeser, Paternalism and Psychology, 73 U. CHI. L. REV. 133
(2006) (arguing that private decisionmaking typically results in better outcomes than
public decisionmaking given the effect of “flaws in human cognition”); Jonathan
Klick & Gregory Mitchell, Government Regulation of Irrationality: Moral and Cognitive
Hazards, 90 MINN. L. REV. 1620 (2006) (utilizing economic and empirically-based
psychological models of decisionmaking competence development to demonstrate
the potential for paternalism to worsen rather than alleviate concerns about irrational
choice). For a critique of behavioral law and economics scholars’ use of empirical
data to support their underlying assumptions, see Gregory Mitchell, Why Law and
Economics’ Perfect Rationality Should Not Be Traded for Behavioral Law and Economics’
Equal Incompetence, 91 GEO. L.J. 67, 73 (2002) (“This article brings to bear a much more
complete set of empirical data than that relied on by the behavioral law and economics scholars to demonstrate the dubious empirical status of the equal incompetence
assumption and, by implication, the dubious status of the behavioral law and economics movement as currently conceived.”); Gregory Mitchell, Taking Behavioralism
Too Seriously? The Unwarranted Pessimism of the New Behavioral Analysis of Law, 43 WM.
& MARY L. REV. 1907, 1945 (2002) (identifying the erroneous application of psychological research by behavioral law and economics scholars).
6 See, e.g., Klick & Mitchell, supra note 5, at 1625-26, 1637.
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the law or the behavior of economic agents, or to predict the consequences of legal change.7 Both neoclassical and behavioral economics stress empiricism. Neoclassicists have traditionally stood behind
Milton Friedman’s statement that a “theory is to be judged by its
predictive power.”8 Behavioral economists interested in its applications to the law have described the goal of their endeavor as producing economic analysis of the law “with a higher R-squared.”9
Christine Jolls also notes that “behavioral economics attempts to
improve the predictive power of law and economics by building in
more realistic accounts of actors’ behavior.”10
This paper focuses on this common interest in predictive
power and empiricism shared by neoclassicists and behavioral
economists. Specifically, I address the question of whether behavioral economic models have increased our knowledge of economic
behavior in the context of what I describe as “consumer contracts.”
While this is a small subset of behavioral economic analysis of the
law, one might reasonably believe that the impact of cognitive biases is greatest in consumer markets where learning, specialization,
and repeat interaction are less likely than in relationships between
firms. An exhaustive survey of the empirical evidence supporting
or contradicting the testable implications of even this subset of behavioral models would be a monumental task. Therefore, I further
limit my empirical investigation to firm exploitation of consumer
biases involving the credit card market, standard form contracts,
and shelf space contracts, and find that the empirical studies of firm
and consumer behavior in these examples do not support the claims
The question is not entirely empirical . The school of thought referred to in this
paper as “behavioral economics” presents a separate methodological critique of the
ability of psychology and economics to displace standard economic theory. See, e.g.,
Faruk Gul & Wolfgang Pesendorfer, The Case for Mindless Economics (unpublished
paper), available at http://economics.uchicago.edu/pdf/Pesendorfer040306.pdf.
8 Milton Friedman, The Methodology of Positive Economics, in ESSAYS IN POSITIVE
ECONOMICS 3, 8 (1953).
9 Jolls, Sunstein & Thaler, supra note 1, at 1487.
10 Christine Jolls, Behavioral Law and Economics, in ECONOMIC INSTITUTIONS AND
BEHAVIORAL ECONOMICS (Peter Diamond ed., Princeton Univ. Press ) (forthcoming
2006).
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that behavioral law and economics generates greater predictive
power than standard price theoretic analysis.
II. Credit Cards
Behavioral law and economics scholars have suggested that
market failure in the credit card market is a function of behavioral
biases that consumers routinely exhibit in borrowing, 11 and that
credit card firms’ exploitation of these biases results in reduced consumer welfare. Professor Oren Bar-Gill, for example, argues that
consumers consistently underestimate their future borrowing due
to a hodgepodge of behavioral biases such as imperfect self-control,
hyperbolic discounting, piecemeal borrowing, and systematically
underestimating the probability of negative consequences (e.g. that
they will be unable to pay their debt or will simply forget that their
bill is due).12 These scholars have argued that short-term features of
credit card contracts such as “teaser rates,” zero annual fees, and
reward programs are not signs of healthy competition in the credit
card market, but rather, of significant consumer welfare losses that
justify paternalistic intervention. A second feature of the behavioral
economic analysis of the credit card market in particular is the posited causal relationship between credit card borrowing and bankruptcy resulting from these biases.13
The hallmark of behavioral accounts of borrowing behavior
in the credit card market is that consumers are “seduced” into a
dangerous slide into debt by issuer competition on short-term features such as rewards programs and teaser rates. Consumers accumulate more debt—and at higher interest rates— than they in-
See, e.g., Cass R. Sunstein, Boundedly Rational Borrowing, 73 U. CHI. L. REV. 249
(2006).
12 Oren Bar-Gill, Seduction by Plastic, 98 NW. U. L. REV. 1373, 1395-1411 (2004); see also
Lawrence M. Ausubel, The Failure of Competition in the Credit Card Market, 81 AM.
ECON. REV. 50 (1991) (asserting that consumer irrationality explains observed pricing
behavior in the credit card market).
13 See, e.g., Lawrence M. Ausubel, Credit Card Defaults, Credit Card Profits, and Bankruptcy, 71 AM. BANKR. L.J. 249 (1997).
11
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tended, leading to reduced welfare and, in some cases, bankruptcy.14 Scholars in this field argue that because consumers are not
sensitive to interest rate changes, competition between sellers exacerbates consumer welfare losses rather than mitigating them;15 thus,
short-term features of credit card contracts such as “teaser rates,”
zero annual fees, and reward programs are not signs of healthy
competition in the credit card market, but traps for unwary consumers that justify paternalistic intervention. 16
One obvious economic question is why these models predict unambiguous consumer welfare losses when sellers compete
by offering greater short-term benefits to consumers until all supracompetitive profits are dissipated.17 Bar-Gill’s model imposes several unrealistic and highly stylized assumptions in order to obtain
the result that such competition always decreases consumer welfare.18 One can, however, imagine a combination of assumptions
Bar-Gill, supra note 12, at 1399-1400.
Id. at 1376 (“[I]f the credit card market is indeed as competitive as it appears to be,
issuers have to exploit consumers’ imperfect rationality in order to survive in this
market.”).
16 See, e.g., Lawrence M. Ausubel, Credit Card Defaults, Credit Card Profits, and Bankruptcy, 71 AM. BANKR. L.J. 249 (1997).
17 For example, Bar-Gill notes that competition is “necessarily” bad for consumers
because “the long-term costs to consumers will generally outweigh the short-term
benefits.” Bar-Gill, supra note 12, at 1411.
18 Bar-Gill’s claim is puzzling given that his model does not specify the conditions
under which this result holds, nor can one derive them because consumer preferences across time periods are not specified, and therefore one cannot analyze the
consumer welfare tradeoffs between consumption over time. Bar-Gill’s model imposes the arbitrary and unrealistic assumption that consumers may not save at the
market- determined interest rate and therefore must consume all of their first period
income. These assumptions do not appear related to any sort of behavioral or cognitive flaw inherent to Bar-Gill’s analysis, but are particularly troublesome in a model
about consumer borrowing behavior and income levels over time, and in light of his
regulatory proposals which include reconsideration of usury laws. Id. at 1416-27.
Further, Bar-Gill assumes that paying an additional $20 in interest because of higher
rates necessarily outweighs the benefits of a $20 reduction in the annual fee because
individuals only carry balances on their credit cards when they have lower income
and therefore have higher marginal utility of income. Id. at 1412. In addition to the
analytical error noted above, the assumption that individuals finance with debt only
when they have low incomes seems inconsistent with the pervasive use of debt by
14
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and consumer preferences that generates some an equilibrium in
which consumer welfare decreases.19 In fact, several recent efforts
by economists to model equilibrium equilibria with irrational consumers, or some combination of rational and irrational consumers,
suggest the possibility of overborrowing and other failures of selfcontrol in markets.20
The critical question for the economic analysis of law is
whether adding bounded rationality and cognitive biases to our
models adds any explanatory power to our existing understanding
of how the credit card market works. The behavioral approach to
credit card competition and borrowing has a number of testable
implications for consumer behavior, long-term interest rates, and
bankruptcy patterns. In this section, I argue that the weight of this
evidence cautions against adopting paternalistic interventions in the
credit card market based upon behavioral explanations of borrowing.
A. Are Credit Card Users Rational After All?
There are a number of empirical studies examining actual
consumer behavior in the credit card market. A comprehensive and
recent study by Tom Brown and Lacey Plache tests the hypotheses
of the behavioral model using a survey of consumer financial behavior commissioned by Visa U.S.A. known as the Payment System
Panel Study (“PSPS”).21 Brown and Plache conclude that hyperbolic
individuals with high incomes and with evidence that the majority of credit card
users do not carry balances at all.
19 See, e.g., David Laibson, Golden Eggs and Hyperbolic Discounting, 112 Q.J. ECON. 443
(1997).
20 See, e.g., Stefano DellaVigna & Ulrike Malmendier, Contract Design and Self Control:
Theory and Evidence, 119 Q.J. ECON. 353 (2004); Xavier Gabaix & David Laibson,
Shrouding Attributes, Consumer Myopia, and Information Suppression in Competitive
Markets (unpublished working paper, April 2005); Alan Schwartz, How Much Irrationality Does the Market Permit? (unpublished working paper, 2005).
21 Tom Brown & Lacey Plache, Paying with Plastic: Maybe Not so Crazy, 73 U. CHI. L.
REV. 63, 77-78 (2006) (describing the PSPS data).
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discounting “does not explain the behavior of credit card issuers
and their customers.”22
Specifically, Brown and Plache are able to directly test the
following predictions of the behavioral models of borrowing behavior:23
(1) Consumers with revolving balances should carry cards
with higher long-term interest rates, lower annual fees,
and higher short-term benefits such as rewards relative
to consumers who do not carry balances on their cards
every month;
(2) Consumers with revolving balances will not substitute
away from the use of credit cards when a new “paynow” alternative, such as a debit card, is introduced.
Brown and Plache examine the first of these predictions by comparing the credit card features selected by non-revolvers and revolvers.24 If the behavioral predictions of debtor behavior are correct,
one would expect to see consumers who revolve debt carrying
cards with no annual fees and higher interest rates than the nonrevolving cohort. Brown and Plache, however, find that more nonrevolvers than revolvers carry cards with average minimum APRs
of greater than 10 percent and note that “this result does not support the hypothesis that hyperbolic discounting results in consumers bearing credit card debt at high interest rates.”25 Brown and Plache also find that while most cardholders do not carry cards with
annual fees, the majority of those that do are revolvers rather than
non-revolvers. Again, the authors note that this result is inconsistent with the behavioral account of consumer “seduction” by short-
Id. at 78.
Id. at 77.
24 Id. at 80-83.
25 Id. at 80 & Figure 2.
22
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term features.26 Finally, Brown and Plache also find that cardholders carrying cards without annual fees or with rewards programs
are less likely to revolve balances than cardholders as a group.27
Sumit Agrawal, Souphala Chomsisengphet, Chunlin Liu,
and Nicholas Souleles (“ACLS”) exploit a natural experiment involving credit card offers from a large U.S. bank to over 150,000
account-holders to test whether credit card consumers’ ability to
select the optimal credit contract.28 ACLS examine consumers’ selection between two credit card contracts, one with an annual fee but a
lower interest rate and a second with no annual fee and a higher
interest rate. The authors then examine post-contract borrowing
behavior in order to assess whether consumers have selected the
optimal credit card contract for their borrowing patterns, defined
by minimizing ex post costs. Importantly, ACLS are also able to
measure the magnitude of any ex post losses flowing from the
choice of a sub-optimal contract. Consistent with Brown and Plache,
ACLS find that the majority of consumers (about 60%) select the
optimal credit card contract. Although a substantial minority of
consumers initially select the “wrong” contract and incur avoidable
interest charges, the authors find that these errors are bounded in
magnitude by the level of the annual fee (typically around $25).
Further, consistent with standard economic theory, the probability
of selecting the sub-optimal credit card contract is decreases with
the cost of the error and increases with repeated consumer error,
suggesting that learning may mitigate the relevant biases.
While these studies do not completely refute the possibility
that behavioral biases cause some consumers to make sub-optimal
decisions, the findings pose a challenge to behavioral scholars. Both
Id. at 81 & Figure 3.
Id. at 81-83 & Figures 4-5.
28 Sumit Agarwal, et al., Do Consumers Choose the Right Credit Contracts? (Dec. 18,
2005)
(unpublished
working
paper,
available
at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=843826); see also Eugenio J.
Miravete, Choosing the Wrong Calling Plan? Ignorance and Learning, 93 AM. ECON. REV.
297 (2003) (presenting evidence that local telephone consumers behave rationally in
selecting contracts and switching tariffs to minimize monthly payments).
26
27
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the frequency and magnitude of sub-optimal credit card contract
decisions appear to be less severe than is assumed in the behavioral
law and economics literature. Further, it is difficult to reconcile
models of irrational consumer behavior with the collective findings
that consumers largely select the right contracts and err less often
when the costs of doing so are higher. The best evidence of at least
some consumer irrationality in this context is that a small minority
of consumers make repeated errors. However, given that the magnitude of error costs are typically small, and perhaps greater than
the effort costs of switching cards ex post, the failure of the some
consumers to correct sub-optimal decisions may also be consistent
with rational consumer behavior.
This empirical evidence is in tension with the simple behavioral theories relied upon in the legal literature, and contradicts the
behavioral predictions that consumers are not sensitive to changes
in contract terms. When coupled with the fact that the majority of
consumers appear not to carry balances at all,29 this evidence suggests that the magnitude of the effects of behavioral biases may be
overstated in the behavioral law and economics literature. Further,
because paternalistic regulation of consumers may reduce incentives to learn (and thus, opportunities to mitigate biases at lower
cost), the wisdom of implementing such regulations is unclear.
A second prediction of the behavioral account of borrowing
is that consumers who carry revolving debt will not substitute away
from credit cards when a new “pay-now” payment method
emerges. Brown and Plache describe the hypothesis as follows:
[I]f people really do not expect to end up in debt when they
use their credit cards, then there is no reason to expect
them to substitute away from credit cards that typically offer a thirty-day float period in addition to other benefits to
See Todd J. Zywicki, An Economic Analysis of the Consumer Bankruptcy Crisis, 99 NW.
U. L. REV. 1463, 1493 n.113 (2005) (citing evidence from a variety of sources estimating the percentage of “convenience” users who do not revolve debt as falling between 55 and 68 percent).
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a new pay-now payment method that offers some of the
benefits of credit cards, such as universal acceptance and
no (or negative) marginal cost, without incurring debt, but
requires immediate payment.30
Brown and Plache show that revolvers responded to the introduction of the general purpose debit card by shifting spending away
from credit cards.31
There is also evidence suggesting that consumer borrowing
behaviors, and particular substitution patterns, respond to the relative prices of alternative forms of debt.32 Specifically, Todd Zywicki
shows that the increase in consumer debt has occurred along with a
corresponding decrease in installment debt burdens, suggesting a
shift in the composition of consumer debt away from less attractive
forms of debt such as pawn shops, check-cashers, and rent-toowns.33 The evidence that consumer substitution patterns are sensitive to relative prices not only suggests rational behavior, but also
indicates that at least some portion of the increase in consumer
credit card debt is a function of consumer preferences for credit
card debt over installment debt. To the extent that consumers are
exhibiting rational switching behavior away from more burden-
Brown & Plache, supra note 21, at 83.
Id. at 84 & Figure 6. Revolvers’ decisions to switch are inconsistent with predictions
that consumers with ex ante beliefs that they will not incur debt will not respond to
such a card, but may also reflect the ex post realization that those beliefs are erroneous. The policy implications of such learning by consumers, followed by increased
sensitivity to interest rates, are unclear for the behavioral theories with generally
assume consistent irrationality.
32 Zywicki, supra note 29, at 1492-97 & Figure 8.
33 Id. at 1494-95 (discussing trends and empirical studies documenting shift to credit
card debt from installment debt). See also Thomas A. Durkin, Credit Cards: Use and
Consumer Attitudes, 1970-2000, 86 FED. RES. BULL. 623, 623-24 (2000); Wendy M. Edelberg & Jonas D. M. Fisher, Household Debt, 123 CHI. FED. LETTER 1, 3 (Nov.
1997)(“[T]he increase in the credit card debt burden for the lowest income group
appears to be offset by a drop in the installment debt burden. This suggests that
there has not been a substantial increase in high-interest debt for low-income households, but these households have merely substituted one type of high-interest debt
for another.”).
30
31
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some forms of debt, it is difficult to understand how the introduction of this additional choice for consumers decreases welfare.
B. “Sticky” Interest Rates and Borrower Rationality
A second characteristic of behavioral accounts of market
failure in the credit card market is the assertion that interest rates
are “sticky”—i.e., not responsive to changes in the opportunity
costs of capital. Behavioral law and economics scholars attribute
this stickiness to the influence of cognitive biases on borrowing behavior.34 To be sure, there is some evidence of sticky interest rates.
The basis for this finding is conventionally attributed to Lawrence
Ausubel’s regression analysis of interest rate changes from 198289.35 Paul Calem and Loretta Mester present additional evidence
that credit card interest rates were sticky during the 1980s and early
1990s.36
Interestingly, however, the periods of time both before and
after this ten year span pose an interesting puzzle for the behavioral
explanation of sticky interest rates. For instance, Zywicki presents
evidence that interest rates were relatively constant not only during
the 1982-89 timeframe in the Ausubel study, during which the opportunity cost of capital was decreasing, but also during the 1970s,
when the cost of funds was increasing.37 For example, from 19721982 the federal funds rate increased from a monthly low of 3.29
percent in February 1972 to a high of 19.10 percent in June 1981.
Therefore, it appears that credit card interest rates from 1972-1992
were invariant to the cost of fund rates in both directions. One
would expect that credit card contracts designed to exploit cogni-
Bar-Gill, supra note 12, at 1383 (“credit card interest rates are not responsive to cost
declines”). See also Susan Block-Lieb & Edward J. Janger, The Myth of the Rational
Borrower: Rationality, Behavioralism, and the Misguided “Reform” of Bankruptcy Law, 84
TEX. L. REV. 1481 (2006).
35 Ausubel, supra note 16.
36 Paul S. Calem & Loretta J. Mester, Consumer Behavior and the Stickiness of CreditCard Interest Rates, 85 AM. ECON. REV. 1327 (1995).
37 Todd J. Zywicki, The Economics of Credit Cards, 3 CHAP. L. REV. 79, 111-19 (2000).
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tive biases would increase interest rates in response to an increasing
opportunity cost of capital.
The evidence also shows that rates are more sensitive to
changes in the cost of capital in recent years, and that credit card
issuers have increasingly competed on interest rates in the years
following Ausubel’s original study.38 For example, Brown and Plache recently evaluated the sensitivity of interest rates to changes in
the opportunity cost of capital form 1995-2004 utilizing the same
PSPS data described above.39 Brown and Plache found, contrary to
the predictions of the behavioral models, that “these rates appear
quite sensitive to the changes in the opportunity cost of capital.”40
For example, Brown and Plache note that in the relevant time period, the return on ten-year treasury notes fell from 6.6 to 4.3 percent, and the spread between interest rates on credit cards and returns on treasury notes fluctuated between 8.3 and 9.3 percent.41
Taken together, the evidence in Parts II.A and II.B suggests
that consumers are sensitive to interest rate changes and exhibit
rational substitution patterns with respect to alternative forms of
debt. In addition, the evidence strongly suggests that consumers
generally select the optimal credit card contract, and that failure to
do so results in minimal losses, which become less likely if the costs
of error are high or if learning is possible. This evidence strongly
undermines the predictions of recent behavioral models relying on
consumer insensitivity to interest rate changes and hyperbolic discounting to advocate paternalistic interventions.42
Id. at 118-19.
Brown & Plache, supra note 21, at 78-79 & Figure 1.
40 Id. at 78.
41 Id; See also DAVID S. EVANS & RICHARD SCHMALENSEE, PAYING WITH PLASTIC: THE
DIGITAL REVOLUTION IN BUYING AND BORROWING 239-40 (MIT Press 2d ed. 2005);
Kathleen Johnson, Recent Developments in the Credit Card Market and the Financial Obligations Ratio, FED. RES. BULLETIN 473, 477(Autumn 2005) (noting that correlation
between credit card interest rates and the prime rate was only 0.09 during the 1980s
and early 1990s but has risen to 0.90 from mid-1990s to present).
42 See Bar-Gill, supra note 12, at 1416-27 (discussing the “consideration” of a variety of
regulatory solutions including increased disclosure, usury laws, and more liberal
discharge of credit card debt in bankruptcy proceedings in response to the “identified failure in the credit card market”); George Loewenstein & Ted O’Donoghue, We
38
39
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C. Behavioral Economics, Credit Cards, and Bankruptcy
Behavioral law and economics scholars point to trends in
bankruptcy filings as evidence of the unique burden imposed on
consumers by credit card borrowing. 43 The underestimation and
hyberbolic discounting hypotheses imply a systematic, gradual, and
unconscious accumulation of debt unique to credit cards, a mechanism that supports the suspicions of some legal scholars that the
credit card market is cause for concern. For example, bankruptcy
scholars Teresa Sullivan, Elizabeth Warren, and Jay Lawrence
Westbrook describe a similar “insidious” process of debt accumulation based on frequent purchases.44 Susan Block-Lieb and Edward
Janger claim that consumers’ increasing debt loads are a function of
lenders’ increasing ability to exploit cognitive biases, and describe
the world of rational borrowers as a “myth.”45 A frequently asserted
claim in this literature is that credit card borrowing causes increased
bankruptcies and therefore justifies intervention in the credit card
market.46
The literature on behavioral economics, credit cards, and
bankruptcy generally centers around two distinct research questions. The first question, already discussed in some detail, is
whether credit card borrowers are rational. Legal scholars have
added to this literature by suggesting aggregate trends in bankruptcy filings, interest rates, debt levels, and other macroeconomic
variables are consistent with irrational consumer behavior. Some
Can Do This the Easy Way or the Hard Way: Negative Emotions, Self-Regulation, and the
Law, 73 U. CHI. L. REV. 183, 204 (2006) (advocating a ban on credit cards); Sunstein,
supra note 11, at 261-63 (discussing “debiasing” campaigns designed to limit the
impact of overborrowing).
43 See, e.g., Bar-Gill, supra note 12, at 1399-1400.
44 TERESA A. SULLIVAN, ET AL., THE FRAGILE MIDDLE CLASS: AMERICANS IN DEBT 10840 (Yale University Press 2000).
45 Block-Lieb & Janger, supra note 34, at 1563. The authors advocate adoption of the
behavioral consumer model, and reject the rational consumer model, for the purposes of designing bankruptcy policy. Id. at 1565 (describing bankruptcy reforms
aimed at the rational consumer as “particularly wrongheaded”).
46 See, e.g., Bar-Gill, supra note 12, at 1385-86, 1411-16 (“mounting credit card debt
fueled by high interest rates is a major cause of consumer bankruptcy”).
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bankruptcy scholars have also addressed a second question, related
to the notion that credit card debt accumulation exploits consumers’
irrational tendencies: does credit card debt cause increased bankruptcy filings?
With respect to the first question, Block-Lieb and Janger
analyzed aggregate data trends and concluded borrowers are not
rational,47 and that “the current bankruptcy filing explosion is better
explained not by strategic borrowers exploiting unwitting lenders,
but by rational lenders exploiting predictable cognitive weaknesses
in consumers.”48 Block-Lieb and Janger frame their empirical challenge to the rational actor model as follows:
In a world of expanding consumer credit and increasing
bankruptcy filings (not to mention increasing profitability
and relatively constant borrowing terms), somebody must
be doing the calculus wrong. Why would rational lenders
with state-of-the-art information technology, universal
credit reporting, and empirically sound risk-management
models knowingly lend to borrowers who are out to game
the system?49
While we have seen that this assertion is inconsistent with consumer-level studies of credit card decisions, it is worth noting that
the aggregate trends highlighted by the authors are also consistent
with the rational actor model despite their declaration to the contrary.
Block-Lieb and Janger highlight what they believe is a tension for the rational actor model: a period of simultaneously increasing bankruptcies, falling credit card rates, constant markups,
47 Block-Lieb & Janger, supra note 34, at 1556. The authors do not address the empirical studies by Brown and Plache or ACLS.
48 Id. at 1525. Block-Lieb and Janger also argue that the consumer opportunism explanation is “a product of the assumption of the instrumentally rational consumer”
and “not driven by the data.” Id. The authors do concede that strategic borrowing in
anticipation of bankruptcy is likely to exist “on the margin.” Id.
49 Id. at 1489.
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and increasing output in the credit card market.50 The authors argue
that the period of increased bankruptcy risk increases lenders’ costs,
which they predict should result in an increase in interest rates or
credit card markups in a world of rational borrowers, but does not.
Instead, interest rates have declined and credit card markups remained relatively constant, facts that the authors declare “significantly undercuts the predictive value of the economic models of
consumer credit.”51
These claims, however, overstate the strength of the empirical case against models of borrower rationality. Most importantly,
bankruptcy losses are not more than a trivial component of lenders’
total costs.52 As the authors acknowledge, the important economic
question is whether lenders’ total costs have increased because of
the increased bankruptcy filings during this time period.53 In fact,
more important components of the lender cost function than bankruptcy losses have decreased substantially over the same time period. For example, an increasing proportion of operating functions
and services, such as electronic account clearing, have become
automated, reducing operating costs and increasing the contribution of the cost of funds as a fraction of total lender costs.54 Consis-
Id. at 1501-08, Figures 2-7. Block-Lieb and Janger’s alternative explanation for this
data is exogenous technological changes allowing lenders enhanced ability to exploit
cognitive biases. Id. at 1565.
51 Block-Lieb & Janger, supra note 34, at 1504, Figure 4.
52 Gross bankruptcy losses to the largest lenders, excluding losses from fraud, from
1994-1997, ranged from 1.74 to 2.9 percent of outstanding credit card balances. See
AM. BANKERS ASS’N, BANK CARD INDUSTRY SURVEY REPORT (various years). The
dominant component of credit card lending costs is operating costs. One estimate
concludes that lenders’ operating costs accounted for approximately 60 percent of
total costs, while the cost of funds was approximately 27 percent. See Glenn B.
Canner & Charles A. Luckett, Developments in the Pricing of Credit Card Services, 78
FED. RES. BULL. 652, 655 n.8 (1992).
53 Block-Lieb & Janger, supra note 34, at 1506 (acknowledging that improvements in
risk-based pricing, increased competition, or reduced administrative or servicing
costs may explain declining interest rates).
54 The apparent anomaly between declining costs of funds and increasing bankruptcy
filings is explained by the decrease in the cost of funds on the composition of credit
card borrowers. A decreasing cost of funds induces marginal consumers to substitute
towards forms of credit that are more sensitive to changes in the cost of funds, such
50
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tent with this technological shock, credit card interest rates have
become less sticky over time.55
Further, innovations in credit card pricing over the past
decade enable lenders to use risk-based, non-linear pricing strategies that allow lenders to price discriminate across consumers and
offer credit to more consumers.56 The increased ability to price discriminate across consumer risk profiles through the use of late fees,
overdraft penalties, and different interest rates—like most forms of
price discrimination—can be expected to increase output.57 While
some have argued that the onset of these terms is also evidence of
lenders’ exploitation of consumer biases,58 we have seen that this
claim is not supported by consumer level evidence demonstrating
that borrowers appear to respond rationally to incentives.
Any test of aggregate trends aimed at generating inferences
about consumer rationality in borrowing decisions makes great
demands of the data. In this case, where the increasing risk of bankruptcy losses is a trivial share of total lending costs, the demands
impose a greater burden than the data can possibly bear. This point
alone, of course, does not refute the possibility that consumers exhibit systematically irrational borrowing behavior. Upon closer ex-
as car loans or home equity loans. Zywicki, supra note 37, at 168. See also Alexander
Raskovich & Luke M. Froeb, Has Competition Failed in the Credit Card Market?, U.S.
Department of Justice Economic Analysis Group Discussion Paper (1992). The inframarginal credit card consumers will be those who have fewer credit options and
therefore one can expect higher-risk borrowers to comprise a higher percentage of
credit card borrowers in periods of falling cost of funds rates, and therefore, expect
default rates to increase. Raskovich and Froeb demonstrate this inverse relationship
between the costs of funds and the default rate. Id.
55 See Zywicki, supra note 37.
56 Block-Lieb & Janger, supra note 34, at 1509-14.
57 For a summary of the economic literature on the welfare effects of price discrimination under various conditions, see Lars A. Stole, Price Discrimination and Imperfect
Competition, in Handbook of Industrial Organization (December 22, 2003), available at
http://web.mit.edu/14.271/www/hio-pdic.pdf; Mark Armstrong & John Vickers,
Competitive Price Discrimination, 32 RAND J. ECON. 579 (2001); Severin Borenstein,
Price Discrimination in Free-Entry Markets, 16 RAND J. ECON. 380 (1985); Kenneth S.
Corts, Third Degree Price Discrimination in Oligopoly: All-Out Competition and Strategic
Commitment, 29 RAND J. ECON. 306 (1998).
58 See Bar-Gill, supra note 12.
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amination, standard economic theory comfortably explains the aggregate data. However, behavioral models that predict that competition produces greater interest rates are unable to explain both the
falling interest rates and the increasing responsiveness of those
rates to a declining cost of funds.
The second empirical question focuses on the nature of the
relationship between credit card debt and bankruptcy filings. Some
have argued that increased bankruptcy filings are the result of
credit card contracts designed to exploit consumer irrationality. An
examination of the empirical literature reveals a consensus that
there is a significant correlation between credit card debt and bankruptcy filings,59 but a number of difficult issues remain with respect
to disentangling and isolating plausible, and possibly co-existing,
mechanisms influencing this relationship.
The simplest way to examine the link between aggregate
credit card debt and bankruptcy filings would be to regress bankruptcy filings in a single country or across countries on credit card
debt and other country-level controls. This specification has a number of drawbacks. The first is the possibility that the specification
suffers from an “omitted variables” problem. The impact of exogenous financial hardship resulting in increased credit card borrowing, and eventually bankruptcy, would be attributed to the increase
in credit card debt. A second possibility is that some debtors strategically borrow in anticipation of filing bankruptcy because such
debt is dischargeable, thus rendering the determination of credit
card debt endogenous to the dependent variable.60 On the margin,
this sort of behavior is likely and consistent with the significant increase in filings prior to the recent bankruptcy reform legislation
and other evidence that some debtors “load up” on dischargeable
See, e.g., Sullivan et al., supra note 44, at 70-72; Ronald J. Mann, Credit Cards, Consumer Credit, and Bankruptcy, AM. L. & ECON. ASS’N ANNUAL MEETING 36 (2006);
Block-Lieb & Janger, supra note 34, at 1521-24; Zywicki, supra note 37, at 1496 (discussing alternative causal explanations for the observed correlation between credit
card debt and bankruptcy filings).
60 Zywicki, supra note 37, at 1496-97.
59
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debt in the period before filing for bankruptcy. 61 This possibility
raises simultaneity issues which render the coefficient estimates on
credit card debt likely biased in ordinary least squares estimation
because it is assumed that changes in bankruptcy filings do not impact credit card debt levels. The empirical challenge is a difficult
one: to isolate these effects in order to uncover the true relationship
between credit card debt and bankruptcy filings using only aggregate filing data and macroeconomic variables.
Two recent contributions to this empirical literature from
legal scholars are noteworthy. Ronald Mann analyzes the impact of
country-level credit card debt, total consumer credit, credit card
spending, and other macroeconomic controls on bankruptcy rates
across five countries with markedly different bankruptcy laws, consumption patterns, and borrowing behavior.62 Mann explicitly motivates his study as an attempt to resolve the endogeneity concerns
discussed above. He regresses bankruptcy filings on credit card
debt lagged by one, two, or three years to ensure he estimates “a
relation that ran from credit card debt to bankruptcy filings rather
than the reverse.”63 Mann finds, perhaps unsurprisingly, that credit
card debt with and without various lags is significantly correlated
with the bankruptcy per capita. From a variety of regressions of this
form, Mann concludes that credit card debt causally increases bankruptcy and a model including only credit card debt, credit card
spending, and total consumer credit explains 90% of the variance in
bankruptcy rates across countries. In a model including countrylevel dummies and macroeconomic variables, the R-squared increased to 97%, a result Mann describes as “striking.”
For example, it is difficult to explain the astronomical increase in bankruptcy filings prior to the enactment of the bankruptcy reforms of 2005 without conceding that
at least some “strategic” borrowing exists. See also David B. Gross & Nicholas S.
Souleles, An Empirical Analysis of Personal Bankruptcy and Delinquency, 15 REV. FIN.
STUD. 319, 338 (2002) (finding that borrowers significantly increase use of their credit
cards in the period prior to filing for bankruptcy).
62 Mann, supra note 59. The five countries are the United States, England, Japan, Australia, and Canada. There are a total of 65 observations across all countries.
63 Id. at 17.
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Despite the interesting correlations reported by Mann, the
statistical evidence presented suffers from a number of flaws. One is
that lagging credit card debt is unlikely to resolve the simultaneity
issues.64 Another is that models including credit card debt, credit
card spending, and total consumer credit likely generate multicollinearity. The fact that controlling for country-specific differences
and macroeconomics conditions only results in a marginal increase
of the R-squared relative to the credit card debt only models from
.90 to .97 suggests that the specification does not properly control
for such differences. It is highly unlikely that country-specific income accounts for only 7% of the variance in the bankruptcy filings
between countries. Further, it seems unlikely that a panel regression
with approximately thirteen observations per country across five
countries with highly variable borrowing and bankruptcy patterns
could possibly generate these goodness-of-fit measures.
The answer to this puzzle, I believe, lies in a specification
error of greater importance than those mentioned thus far. Mann’s
Figure 4 illustrates a scatterplot of one-year lagged credit card debt
and bankruptcy rates and appears to include all 65 observations
and a fitted trend line through the observations. Recall that each
observation is a pair containing credit card debt and bankruptcy
filing rates for a particular year. Figure 4 suggests that the model is
not a panel regression at all and therefore does not distinguish between observations in particular countries or over time. In essence,
One conventional solution to the simultaneity issue would be to use an instrumental variable estimator: a set of variables which are: (1) uncorrelated with the errors, in
this case the unobserved factors impacting the financial situation of borrowers and
therefore the use of debt and the propensity to file for bankruptcy; (2) correlated with
the endogenous independent variable, in this case credit card debt; and (3) are unrelated to the dependent variable, in this case bankruptcy filings, except through its
influence on credit card debt. As is typically the case with selecting instruments, the
greater the correlation between the instrument and the endogenous independent
variable the more likely the instrument violates the first condition. In this case,
lagged credit card debt is likely an insufficient instrument because it is correlated
with the omitted variables influencing the borrower’s financial well-being and, therefore, propensity to file for bankruptcy. On instrumental variables estimation, see
WILLIAM H. GREENE, ECONOMETRIC ANALYSIS 288-95 (3rd ed. 1997).
64
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the model is an OLS regression of bankruptcy filing rates on credit
card debt as if each observation represented a unique country in a
cross-sectional analysis. The model cannot possibly explain the
variance in filing rates between countries and over time. This would
explain, for example, why country level GDP and unemployment
play no significant role in explaining bankruptcy filings rates. Including GDP in this model is unlikely to add explanatory power
because the model does not control for the impact of a change in
Japan’s GDP on Japan’s filing rate. Though Mann does introduce
country dummies in one specification, the analysis does not exploit
the variation within countries over time and purports to explain
only the impact of country specific changes on the average level of
filing across all five countries.
Assuming this critique is correct, Mann’s analysis does not
shed any additional light on the relationship between credit card
debt and bankruptcy rates controlling for country-level differences.
In order to exploit the variation both between countries and within
countries over time, one would ideally like to use panel data estimation techniques. However, that approach is not likely to be fruitful given only a handful of observations in each country. Alternatively, one might control for within-group variation over time by
including a time trend along with country-level controls though this
would not completely account for the aforementioned endogeneity
problems. Mann’s primary result—the significant correlation between credit card debt and bankruptcy filing rates—disappears
with this specification.65
A second recent contribution to this literature is Robert
Lawless’ time-series analysis of credit card debt and bankruptcy
filing rates in the United States.66 Lawless analyzes the extent to
which previous attempts to reform bankruptcy laws have impacted
See TODD J. ZYWICKI, BANKRUPTCY AND PERSONAL RESPONSIBILITY: BANKRUPTCY
LAW AND POLICY IN THE TWENTY-FIRST CENTURY (Forthcoming Yale University Press,
2007).
66 Robert M. Lawless, The Paradox of Consumer Credit 63 (Univ. Ill. Law & Economics
Research Paper Series, Paper No. LE06-015, April 2006), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=906868.
65
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filing rates and finds a significant negative relationship between
consumer debt and bankruptcy and a significant positive relationship with the square of consumer debt. These results suggest that
additional borrowing reduces bankruptcy filing for some level of
consumer debt, but increases the propensity to file above some
threshold level. Lawless also reports that increased consumer credit
is associated with a significant and immediate decline in bankruptcy filings, but is followed by an equally significant increase in
filings a few years later. Taken together, Lawless’ results suggest
that the relationship between credit card debt, consumer debt, and
bankruptcy filings is considerably more complex than the simple
hypothesis posed by the behavioral account of a gradual and “insidious” slide into insolvency. The results also pose a challenge to
the hypothesis that lenders ramp up borrowing in anticipation of
filing because the surge in bankruptcies comes a year after aggregate credit card debt increases. These data raise important questions
to be addressed in terms of specifying the dynamics of the relationship between consumer debt and bankruptcy.
The literature on the complex relationships between credit
card debt, borrowing behavior, and bankruptcies is developing, and
creative empirical strategies are necessary to isolate components of
this relationship. The state of the evidence, however, lags well behind the claims in the legal literature that consumer borrowing behavior is irrational, that this irrationality generates a causal link between credit card debt and bankruptcy, and that legal reform
should be based on the behavioral models of consumer borrowing.
To the contrary, the weight of the available evidence is consistent
with neoclassical conception of the rational consumer.
III. Standard Form Contracts
Economists and legal scholars have long been interested in
standard form contracts and their terms. Economists have generally
found standard form terms innocuous so long as sufficient competition exists at the time of contracting. Economists have also focused
on the role of contract terms, particularly terms that appear “unfair”
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or give discretion to one party, in establishing self-enforcing contractual arrangements. For example, Benjamin Klein’s analysis
shows that where third-party enforcement is costly, sellers are
likely to rely on their substantial but scarce reputational capital
when dealing with consumers, which reduces the costs of contracting but requires protection against opportunistic behavior by the
buyer.67 Others have identified the theoretical possibility that a monopolist’s insensitivity to consumer preferences will result in suboptimal contract terms, though the empirical evidence does not
clearly support this proposition.68
Despite the ubiquity of standard form contracts in competitive markets, legal scholars and courts have long viewed standard
form terms with a skeptical eye, associating them with monopoly
power 69 or some related, but poorly-defined, coercive force that
compels consumers to accept unfavorable terms. 70 In response to
this view, some courts will refuse to enforce standard form contracts offered by sellers with substantial bargaining power under
limited circumstances.71
The standard behavioral law and economics account supports this suspicion of standard form terms. This challenge depends
on the apparently widely accepted and frequently discussed assumption that consumers are subject to a number of systematic be-
See Benjamin Klein, Transaction Cost Determinants of “Unfair” Contractual Arrangements, 70 AM. ECON. REV. 356-62 (1980). For an analysis of standard form terms relying on similar logic, see Lucian A. Bebchuck & Richard A. Posner, One-Sided Contracts
in Competitive Consumer Markets, 104 MICH. L. REV. 827 (2006).
68 See Florencia Marotta-Wurgler, Competition and the Quality of Standard Form Contracts: An Empirical Analysis of Software License Agreements (unpublished paper, New
York University School of Law, Aug. 22, 2005) (discussing the state of empirical literature and presenting evidence that the quality of software license terms does not
decrease with reduced competition).
69 See Friedrich Kessler, Contracts of Adhesion – Some Thoughts about Freedom of Contract, 43 COLUM. L. REV. 629 (1943).
70 See, e.g., ROBERT COOTER & THOMAS ULEN, LAW AND ECONOMICS 279 (2000);
RICHARD A. POSNER, ECONOMIC ANALYSIS OF THE LAW 126-28 (1998).
71 See, e.g., U.C.C. § 2-302(1); E. ALLEN FARNSWORTH, CONTRACTS § 4.28 (2d ed. 2001);
RESTATEMENT (SECOND) CONTRACTS § 208 (1981).
67
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havioral biases and cognitive quirks.72 Specifically, the behavioral
law and economics account begins with the dual premises that purchasing decisions will be “sufficiently complex that buyers will be
selective in their consideration of product attributes,” 73 and that
standard form terms are especially likely not to influence the consumer’s purchase decisions because “their usual content makes
them unlikely to attract buyers’ voluntary or involuntary attention.” 74 While laboratory experiments appear to support these
premises, the challenge for behavioral law and economics has been
to map these findings into a coherent theory about behavior in
markets characterized by specialization, learning, and repeated interaction.
Professor Russell Korobkin attempts to deliver such a theory. The model is simple and superficially appealing. Korobkin assumes that buyers compare only limited numbers of product attributes when contemplating purchase, and claims that competition
between sellers will generate efficient quality terms for those attributes which buyers consider “salient,” but low-quality terms regarding non-salient attributes.75 The lynchpin of the theory is that sellers
are unable to recoup the costs of offering efficient non-salient terms
and that this condition worsens with increasing competition.76 This
72 For examples of these proposals in the standard form contract context, see Oren
Bar-Gill, supra note 12; Paul Bennett Morrow, The Unconscionability of a Liquidated
Damages Clause: A Practical Application of Behavioral Decision Theory, 22 PACE L. REV. 27
(2001); Matthew T. Bodie, Questions About the Efficiency of Employment Arbitration
Agreements, 39 GA. L. REV. 1 (2004).
73 Russell Korobkin, Bounded Rationality, Standard Form Contracts, and Unconscionability, 70 U. CHI. L. REV. 1203, 1225-26 (2003).
74 Id. at 1226.
75 Id. at 1206.
76 Id. at 1243-44. Jonathan Klick challenges this conclusion by arguing that low probability events have the potential to change consumers’ salience profiles, and the occurrence of these events imposes a reputational sanction on firms offering inefficient
terms. Jonathan Klick, The Microfoundations of Standard Form Contracts: Price Discrimination v. Behavioral Bias, 32 FLA. STATE U. L. REV. 555 (2005). The stability of salience
profiles raises a number of issues. A firm with a competitive advantage in offering
non-salient terms may not simply surrender to the buyers’ non-salience. For example, such a firm might attempt to attract attention to their inclusion of favorable
terms or educate consumers’ about their value. The conditions under which ineffi-
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analysis leads Korobkin to make the startling claim that competition
not only does not ameliorate the impact of consumer irrationality,
but also simultaneously reduces both consumer welfare and producer surplus.77 This consumer welfare result is the foundation for
Korobkin’s proposal to modify the unconscionability doctrine to
protect behaviorally biased consumers from competition.78
The behavioral law and economics account of competition
with standard-form contracts raises some interesting questions in
terms of consumer welfare analysis. Presumably, in a zero-profit
equilibrium with completely irrational consumers, sellers will compete by offering more favorable salient terms (and worse nonsalient terms) than would prevail in a world of rational consumers.
This begs the question of the welfare trade-offs inherent in this
lower price and lower quality world. Korobkin avoids this issue
altogether by failing to recognize that sellers will compete by lowering the price (or improving other salient features); he asserts that
sellers will offer the same prices to behaviorally-biased consumers as
they would to fully rational consumers. The flawed economic logic
that sellers will not reduce prices below the level that would prevail
in a world of fully rational consumers drives Korobkin’s startling
result that sellers are also worse off with competition on standard
form contracts.79 However, once one recognizes that a zero-profit
equilibrium requires sellers to lower the price relative to the rational equilibrium world, it follows that sellers will increase total
sales relative to the “rational consumer” equilibrium.
These flaws undermine, but are not fatal, to the behavioral
attack on standard form contracts on consumer protection grounds.
It is possible that the lower price and lower quality equilibrium
would result in lower consumer welfare under some conditions.80
cient standard form contracts would persist in equilibrium with endogenous salience
profiles are unclear.
77 Korobkin, supra note 73, at 1242-44.
78 See id. at 1278–79.
79 Id. at 1235-36.
80 See, e.g., Carl Shapiro, Aftermarkets and Consumer Welfare: Making Sense of Kodak, 63
ANTITRUST L.J. 483, 511 (1995) (demonstrating that potential consumer welfare losses
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But the question remains whether the behavioral account helps us
to understand the nature of competition with standard form contracts. The key feature of the behavioral account, which distinguishes it from the neoclassical approach, is the perverse relationship it predicts between competition and the quality of “nonsalient” terms. In theory, this prediction allows for a very simple
test of the behavioral approach if one can operationalize nonsalience. If the consumers are unable to price “non-salient” terms,
and the behavioral account has predictive power, we should observe the quality of “non-salient” standard form terms decrease
with more competition.
There is a good deal of evidence documenting the relationship between standard terms and competition, and a substantial
theoretical literature on the relationship between competition and
product quality, where standard form terms are conceived of as
product attributes.81 The empirical industrial organization literature
documents a relationship between competition, typically measured
by market concentration, and product quality.82 However, very few
in the analogous aftermarket context are small relative to the deadweight losses associated with monopoly pricing).
81 See generally JEAN TIROLE, THE THEORY OF INDUSTRIAL ORGANIZATION (1988); Lewis
Kornhauser, Unconscionability in Standard Forms, 64 CAL. L. REV. 1151, 1179 (1976)
(standard form term quality increases with competition); A. Michael Spence, Monopoly, Quality, and Regulation, 6 BELL J. ECON. 417 (1975); Alan Schwartz & Louis Wilde,
Intervening in Markets on the Basis of Imperfect Information: A Legal and Economic Analysis, 127 U. PA. L. REV. 630 (1979); Richard Schmalansee, Market Structure, Durability,
and Quality: A Selective Survey, 17 ECON. INQUIRY 177 (1979) (summarizing the conditions under which monopolists provide lower quality); Victor P. Goldberg, Institutional Change and the Quasi-Invisible Hand, 17 J.L. & ECON. 461 (1974); Avery Katz,
Your Terms or Mine? The Duty to Read Fine Print in Contracts, 21 RAND J. ECON. 518
(1990).
82 See, e.g., Michael J. Mazzeo, Competition and Service Quality in the U.S. Airline Industry, 22 REV. INDUS. ORG. 275 (2003) (finding a negative relationship between market
concentration and quality in the airline industry); Stephen Foreman & Dennis Shea,
Publication of Information and Market Response: The Case of Airline on Time Performance
Reports, 14 REV. INDUS. ORG. 147 (1999) (same); Caroline M. Hoxby, Does Competition
Among Public Schools Benefit Students and Taxpayers, 90 AM. ECON. REV. 147 (2000).
Florencia Marotta-Wurgler summarizes this literature in Marotta-Wurgler, supra note
68, at 8-10. See also David Dranove & William D. White, Recent Theory and Evidence on
Competition in Hospital Markets, 3 J. ECON. & MGMT. STRATEGY 169 (1994).
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studies have focused on the precise question posed by the behavioral literature: the relationship between competition and product
quality as measured by standard form terms. The few studies that
have examined this relationship, however, do not find the negative
relationship between competition and quality of standard form
terms predicted by the behavioral approach. George Priest’s seminal examination of household appliance warranties did not find a
significant relationship between restrictive warranty terms and
firm-specific market share or industry concentration.83
The most recent and comprehensive analysis of the relationship between competition and standard form terms is Florencia
Marotta-Wurgler’s examination of software end-user license
agreements (“EULAs”). 84 Marotta-Wurgler collects a remarkably
large sample of 647 EULAs from 598 companies and categorizes
each into a product market consistent with Amazon.com’s classification system. In addition, Marotta-Wurgler measures the content
of each EULA using an index on 25 common standard terms in
seven categories. Marotta-Wurgler measures the quality of these
EULA terms by adding (subtracting) one point if the term is more
pro-buyer (pro-seller) than the Article 2 default rule, and assigning
a score of zero if the EULA is silent with respect to the term. Aggregating these scores to create a “bias index” for standard form terms
that roughly measures the pro-buyer features of EULAs, MarottaWurgler proceeds to examine the extent to which product and
company characteristics, including market share, 85 explain EULA
bias and product price.
Consistent with standard economic theory, MarottaWurgler finds that less competition is associated with higher product prices. The study also finds no significant relationship between
George L. Priest, A Theory of the Consumer Product Warranty, 90 YALE L.J. 1297
(1981).
84 Marotta-Wurgler, supra note 68.
85 Judith Chevalier and Austan Goolsbee, Measuring Prices and Price Competition
Online: Amazon.com and BarnesandNoble.com, 1 QUANTITATIVE MKTG. & ECON. 203
(2003) (following this methodology, Marotta-Wurgler transforms Amazon.com sales
rank data to market share figures).
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competitive conditions and EULA bias; higher concentration or firm
market share does not lead to terms less favorable to consumers, as
is predicted by the behavioral models. Korobkin hypothesizes that
consumers may only focus on “salient terms” and therefore increased competition will have a negative impact on certain subsets
of terms. To the contrary, Marotta-Wurgler finds no significant
“competition effect.” These results contradict the predictions of the
behavioral model, but are not in tension with price theory.
Admittedly, few studies directly test the behavioral account
of standard form contracts, but both Priest’s and Marotta-Wurgler’s
results are inconsistent with the prediction that non-salient terms
decrease in quality as competition increases. Further, the empirical
economics literature documents a relationship between competition
and product quality more generally, that suggests the behavioral
account neither explains what we observe in standard form contracts nor forms an appropriate foundation for policy analysis.
IV. SHELF SPACE CONTRACTS
Supermarkets are another excellent laboratory for testing
the predictive power of behavioral models. Jon Hanson and Douglas Kysar describe the modern supermarket as “a marketing marvel,” which “vividly illustrates consumer susceptibility to manipulation,” and symbolizes the “untold manipulation” of which competitive markets are capable.86 For the irrational consumer plagued
by behavioral biases, the supermarket represents a confusing maze
of atmospherics, a constant barrage of in-store advertising, and the
constant need to defend against firm attempts to exploit these biases through inducing “impulse” purchases. Hanson and Kysar
discuss in great detail what they describe as the “sleight of hand”
carried out in supermarkets to influence consumer behavior.87
86 Jon D. Hanson & Douglas Kysar, Taking Behavioralism Seriously: Some Evidence of
Market Manipulation, 112 HARV. L. REV. 1420, 1444 (1999).
87 Id. at 1444-50.
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The proposition that retailers attempt to influence consumers’ shopping experiences, often with manufacturer cooperation
and funding, is not controversial. Supermarkets compete for the
favor of customers and to increase purchases by using music to influence the mood of shoppers, designing the store layout to maximize sales, by locating impulse items at the checkout counters, and
by placing staple items on opposite ends of the store to increase total shopping time. Manufacturers also spend billions of dollars annually on point-of-purchase advertising and premium shelf space.
Manufacturers and retailers analyze scanner data and use computer
simulations to inform shelf space allocation decisions.88 The decision to place a particular brand of soda or breakfast cereal in the
highly valuable eye-level real estate is not random, but the outcome
of a complex decision-making process that is the outcome of the
competitive process and designed to maximize profit. In many
cases, the shelf space placement decision involves an agreement
between the manufacturer and retailer called a “slotting contract.”
Retailers, including supermarkets, also increasingly make use of
category management, a marketing principle which delineates the
store into distinct product categories, each managed by a supplier,
to maximize category profits.
Hanson and Kysar’s collection of evidence is an important
descriptive analysis of the reality of supermarket competition. Indeed, Hanson and Kysar’s description of “real world” supermarket
competition offers a fertile field for assessing whether market-based
exploitation of consumer cognitive biases harms consumers or is
more consistent with neoclassical economics. To be sure, these realities also present a challenge for the standard economic models of
product distribution, where it is assumed that retailers’ only function is to reduce search costs and passively transmit exogenous consumer preferences. The relevant question for our purposes is
whether behavioral economics provides a better explanation of
For an economic analysis of category management in retail distribution, see Joshua
D. Wright, Antitrust Analysis of Category Management: Conwood v. United States Tobacco
Co. (unpublished paper, available from author).
88
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these realities of shelf space competition than neoclassical economics. The answer to this question must be extracted from the data.
This section proceeds in three steps. The first is to sketch a
stylized behavioral theory of shelf space allocation grounded in
Hanson and Kysar’s description of “market manipulation” and derive testable implications. The second step is to test the predictions
against available empirical evidence regarding shelf space contracts.
The last step is to demonstrate that manufacturers’ efforts to maximize impulse and unplanned purchases are not inconsistent with
conventional economic analysis.
A. “Market Manipulation” Theory of Shelf Space Allocation
Hanson and Kysar offer an informal theory of supermarket
competition as firm exploitation of behavioral biases. The research
of other behavioral law and economics scholars, such as Oren BarGill’s recent behavioral account of bundling in competitive markets
as a response to consumer misperception, 89 is illustrative of the
mechanism by which such manipulation could result in consumer
harm. Bar-Gill contemplates firm responses—specifically the bundling of products—to consumers’ inability to accurately value all
components of a product, e.g., misestimating how much ink the
buyer will ultimately consume when purchasing a printer. 90 BarGill argues that bundling in response to consumer misperception
may decrease consumer welfare under some conditions. The theoretical net cast by such an account is incredibly broad. One can conceive of most products sold today as a “bundle” of product characteristics. Grocery products and premium shelf space might reasonably be viewed as such a bundle, where the product package
consists of both the product and its location on the shelf. If consumers overestimate shelf space value, and are irrationally prone to
changes in shelf space allocation, one can conceptualize competition
between sellers for scarce shelf space as a process to extract con-
89
90
Oren Bar-Gill, Bundling and Consumer Misperception, 73 U. CHI. L. REV. 33 (2006).
Id. at 33.
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sumer surplus from behaviorally biased consumers.91 The ultimate
question is whether the theory of shelf space allocation decisions
and contracting as an exploitative response to the presence of consumer biases explains what we observe in the market for shelf space
better than existing theories which rely on the tools of neoclassical
economics. There are several testable implications of the market
manipulation explanation for shelf space contracts:
(1) Generally, competition between sellers exacerbates,
rather than mitigates, consumer biases.92 Slotting contracts—agreements involving payments from manufacturers to retailers for premium shelf space—should
therefore occur with greater frequency in more competitive markets .
(2) Habitual consumers of a particular product are less
likely to overestimate their willingness to pay for that
product, or to fall victim to shelf space framing effects.
Therefore, ceteris paribus, we should observe less intense
use of slotting contracts and shelf space manipulation
should result where a significant fraction of sales are
the result of repeat purchase.
(3) Market manipulation by use of shelf space contracts
should remain relatively constant over time unless consumer biases or susceptibility to manipulation has increased.
Bar-Gill mentions bundles of products and promotional services such as showrooms and knowledgeable salespersons. Id. at 54. I do not mean to imply that bundling is the only behavioral story one can tell about supermarket shelf space allocation. For instance, one can also imagine a story where shelf space decision is motivated by exploiting “framing” effects or changes in consumer preferences for a
product which are a function of the surrounding products.
92 See, e.g., Bar-Gill, supra note 89 at 40; Korobkin, supra note 73, at 1243–44.
91
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(4) The shelf space manipulation theory suggests that slotting contracts generate supra-competitive profits for
both suppliers and supermarkets. Thus, supracompetitive supermarket profits should coincide with
the widespread increase in the use of shelf space contracts over the past twenty-five years.
B. Testing the Shelf Space Manipulation Theory
Systematic evidence about slotting contracts is sparse and
largely anecdotal. Klein and Wright have collected and analyzed
the available evidence on slotting contract terms, as well as which
products are covered under those terms, the characteristics of those
products, and the increase in slotting in magnitude and frequency
over time.93 Klein and Wright also present an economic explanation
of slotting contracts, which relies on the standard economic assumptions that consumers and firms are rational. I will discuss the
performance of Klein and Wright’s promotional services theory in
Part C. With regard to the predictions of the behavioral account, the
data reject three of these predictions and are ambiguous as to the
fourth.
The evidence is ambiguous with respect to the prediction
that slotting contracts will be more prevalent when product markets
are more intensely competitive. If consumers do not place the correct value on shelf space due to cognitive bias, behavioral models
have predicted that competition leads to larger incentives to manipulate consumers. There is little systematic data regarding the
correlation between the incidence of slotting contracts and objective
measures of competitiveness such as industry concentration or firm
market share, though anecdotal evidence suggests that this prediction does not hold. For instance, while firms with relatively small
market shares utilize slotting contracts, recent antitrust cases involving slotting have involved firms with high market shares oper-
Benjamin Klein & Joshua D. Wright, The Economics of Slotting Contracts, 50 J. LAW &
ECON. (forthcoming Aug. 2007).
93
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ating in relatively concentrated industries, such as Philip Morris,
Barnes and Noble, Gerber, Coca-Cola, United States Tobacco, and
McCormick Spice Company.94 Nonetheless, the lack of systematic
evidence regarding the competitive conditions in industries where
there is greater intensity of slotting activity prohibits any definitive
conclusions.
The behavioral model of shelf space competition also predicts less frequent “market manipulation” for incumbent, repeatpurchase products with established demand relative to new products. For example, one would not expect consumers who prefer
Pepsi to repeatedly purchase Coke because of favorable shelf space
allocation if the product disappoints. Slotting contracts, however,
are pervasively used not only by Coca-Cola, but also by tobacco
companies, whose products involve frequent repeat purchases and
established demand.95 Klein and Wright show that the prevalence
of slotting contracts follows a very interesting and predictable pattern, specifically that they systematically occur in product categories with significantly higher manufacturer margins—measured by
94 See, e.g., R. J. Reynolds Tobacco Co. v. Philip Morris Inc., 199 F. Supp. 2d 362, 388,
390 (M.D.N.C. 2002), aff’d per curiam, 67 F. App’x 810 (4th Cir. 2003); Conwood Co. v.
United States Tobacco Co., 290 F.3d 768 (6th Cir. 2002); American Booksellers Ass’n,
Inc. v. Barnes & Noble, Inc., 135 F. Supp. 2d 1031 (N.D. Cal. 2001); Intimate Bookshop, Inc. v. Barnes & Noble, Inc., 88 F. Supp. 2d 133 (S.D.N.Y. 2000); FTC v. H.J.
Heinz Co., 116 F. Supp. 2d 190 (D.C.C. 2000), rev’d, 246 F.3d 708 (D.C. Cir. 2001); FTC
v. McCormick, FTC Docket No. C-3939 (2000). Slotting fees and other forms of shelf
space payments were also central to Coca-Cola’s 2004 settlement with the European
Commission. See Undertaking, Case Comp/39.116/B-2-Coca-Cola, available at
http://europa.eu.int/comm./competition/antitrust/cases/decisions/39116/
tccc_final_ undertaking_041019.pdf.
95 Klein & Wright, supra note 93; Joshua D. Wright, Slotting Contracts and Consumer
Welfare, 74 (2) ANTITRUST L.J. (forthcoming 2007) (documenting use of slotting contracts in military commissaries for thousands of incumbent products); FEDERAL
TRADE COMM’N, REPORT ON THE FEDERAL TRADE COMM’N WORKSHOP ON SLOTTING
ALLOWANCES AND OTHER MARKETING PRACTICES IN THE GROCERY INDUSTRY 29 n. 94
(2001), http://www.ftc.gov/os/2001/02/slottingallowancesreportfinal.pdf (last
visited Jun. 26, 2007) [hereinafter FTC Report]; Staff Study, FED. TRADE COMM’N,
SLOTTING ALLOWANCES IN THE RETAIL GROCERY INDUSTRY: SELECTED CASE STUDIES IN
FIVE PRODUCT CATEGORIES 19 n.92, 57 (Nov. 2003)), available at
http://www.ftc.gov/os/2003/11/slottingallowancerpt031114.pdf.
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the ratio of value added to the value of shipments—than those
where slotting has not been reported to occur.96
Additionally, behavioral theories cannot explain the time
series evidence regarding slotting contracts. Over the last twenty
years, the market for slotting contracts has changed considerably.
During this period, the prevalence and magnitude of slotting contracts increased.97 Further, the form of slotting contracts changed in
the early to mid-1980s, from discounts from the manufacturer’s
wholesale price to the use of lump-sum, per-unit time payments.98
This time series evidence poses a challenge for any theory of shelf
space contracts. Behavioral theory implies that, because such contracts are a reaction designed to manipulate and exploit consumer
cognitive biases, either manufacturers’ and retailers’ abilities to exploit consumers or the magnitude of the relevant consumer biases
must have increased over the same time period. There is little evidence to support the latter possibility, but one might believe that
the former is supported by the introduction of scanner data technology in 1981, which may allow firms to more efficiently manipulate consumers’ cognitive shortcomings through the use of shelf
space allocation. However, this change would impact all product
categories and not just those with high margins. Additionally, the
behavioral theory cannot explain the increased tendency to compensate retailers for shelf space with per unit time payments rather
than discounts from the wholesale price that occurred in the mid1980s.
A fourth testable implication involves supermarket profitability. If market manipulation of shelf space allows retailers to extract additional surplus from consumers, the manipulation theory
Klein & Wright, supra note 93, at Table 2. Klein and Wright are able to reject the
null hypothesis that the median value added relative to sales for products with slotting equals the median for products without slotting, using the Wilcoxon Rank Sum
test, at the .01 level. Id. Adam Rennhoff, Promotional Payments and Firm Characteristics:
A Cross-Industry Study (unpublished working paper, on file with author, 2004), available at http://www.pages. drexel.edu/~adr24/ accounting3-18.pdf, also finds a
significant correlation between high manufacturer margins and slotting.
97 FTC Report, supra note 95, at 4, 11 & n.18-19.
96
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predicts that retailers would have experienced an increase in profitability over the past twenty-five years during which shelf space
contracts have increased in frequency and magnitude. To the contrary, Klein and Wright show that there is no positive association
between increased slotting contracts and supermarket profitability.99
Finally, it is worth noting that the existence of slotting contracts poses a challenge for behavioral theories. If supermarket retailers are aware of these consumer biases—a proposition that lies
at the very heart of Hanson and Kysar’s analysis—this raises a fundamental economic question: why would retailers not choose the
mix of products and shelf space allocation that maximized profit,
including the profits earned by exploiting these biases, without a
separate contract with the manufacturer? In other words, why must
the manufacturer compensate the retailer here at all? If shelf space
contracts are a function of behavioral biases, one must believe that
manufacturers and retailers have different incentives to exploit
these biases in order to explain the existence of the contract itself.
The question remains whether an economic analysis of supermarkets assuming rational consumers bears more explanatory fruit than
its behavioral cousin. I argue that it does.
C. An Alternative Explanation of Shelf Space Contracts: The Promotional Services Theory
Klein and Wright present a “promotional services” economic explanation of slotting contracts which is consistent with the
available data and assumes, contrary to the behavioral accounts,
that consumers are rational.100 The fundamental assumption behind
the promotional services theory is that retailer shelf space is a form
of promotion which induces additional sales of the featured prod-
Klein & Wright, supra note 93, at 6 n.12.
Klein and Wright, supra note 93, Fig. 2, n. 31.
100 Id. at 9.
98
99
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uct.101 Contrary to conventional economic models that assume that
retail only exists to reduce shopping costs, supermarkets in the real
world, the world described by Hanson and Kysar, have the ability
to influence consumers’ purchasing decisions by altering shelf space
and display allocations. Klein and Wright demonstrate that where
retailer shelf space induces profitable incremental sales and consumers do not engage in substantial store switching in response to
shelf space allocation decisions, shelf space contracts are a consequence of the normal competitive process because retailers do not
have the incentive to provide the joint profit-maximizing amount of
shelf space under these conditions.102
In contrast to the behavioral account of supermarket shelf
space decisions, the promotional services theory correctly implies
that slotting will be positively related to manufacturer incremental
profit margins, a fact that explains both the growth and the incidence across products of slotting in grocery retailing. Further, the
theory explains the prevalence of slotting contracts for new and incumbent products, as well as those which consumers’ purchase repeatedly, such as Coca-Cola. In sum, the promotional services theory explains the existing data where the behavioral theory does not.
Hanson and Kysar’s supermarket analysis illustrates both
fundamental similarities and differences between behavioral and
price-theoretic approaches to consumer contracts. On the one hand,
Hanson and Kysar’s realistic description of supermarket shelf space
decisions and deliberate design of store layouts to maximize profit
tell a tale that is not reflected in standard economic models of retail
which focus exclusively upon retailers’ ability to reduce search
costs. Their account therefore poses a very real and important chal-
Numerous marketing studies support this proposition. See Adam Rennhoff, Paying for Shelf Space: An Investigation of Merchandising Allowances in the Grocery
Industry (unpublished working paper, on file with author, July 2004); Xavier Dreze,
et al., Shelf Management and Space Elasticity, 70 J. RETAILING 301 (1994); Charles Areni,
et al., Point-of-Purchase Displays, Product Organization, and Brand Purchase Likelihoods,
27 J. ACAD. MKTG. SCI. 248 (1999).
102 This incentive incompatibility problem is the retailer insufficient supply of promotion problem first illustrated in Benjamin Klein and Kevin M. Murphy, Vertical Re101
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507
lenge to neoclassical economists to explain some of the observed
facts that appear inconsistent with the economic standard models,
which assume a very passive role for the retailer. Both the behavioral and promotional services theory share the desire to engage in
“real world” economics, accepting the reality that supermarkets do
indeed have the ability to influence consumer purchasing decisions
in a myriad of ways. Each theorist makes decisions regarding which
descriptive features of the market to include in the model based
upon concerns of tractability and contributions to predictive power,
including consumer rationality.
Despite the similarities in methodologies, and the shared
interest in predictive power, there also appears to be a considerable
chasm between the two approaches. A behavioral economist might
respond to the well-established empirical result that premium shelf
space increases sales by arguing that this evidence supports the behavioral theories arguing that consumer willingness to pay for this
display space is ultimately irrational. After all, one might suggest,
Coke tastes like Coke whether purchased from the bottom or top
shelf. But this argument boils down to whether consumer willingness to pay for “non-informative” advertising is rational. The notion
that consumer demand is a function of both price and demandincreasing services, such as promotion, is not new to price theory.103
But perhaps consumers’ positive consumer reactions to shelf space
are irrational because they are unlike product demonstrations and
point-of-sale services which provide valuable information to consumers? The view that consumer willingness to pay for “noninformative” advertising or investments in brand names is irrational relies on the dual assumptions that consumers do not generate utility from consuming the promotional service and that the sole
legitimate economic function of advertising is to supply information about the product.
straints as Contract Enforcement Mechanisms, 31 J.L. & ECON. 265 (1988).
103 See, e.g., Lester G. Telser, Why Should Manufacturers Want Fair Trade?, 3 J.L. &
ECON. 86 (1960).
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These assumptions ignore, and perhaps implicitly reject,
long-standing arguments by economists that consumers may rationally value even so-called “non-informative” advertising such as
celebrity endorsements, commercials, sponsorships of athletic
events, and charities. Benjamin Klein and Keith Leffler’s seminal
analysis of the role of advertising demonstrates the role of a nonsalvageable investment in advertising in signaling the presence of a
large selling cost and existence of a price premium.104 Consumers
with imperfect information rely on brand names and advertising
instead of investing large amounts of time to learn all the details
about a company’s product. In the Klein and Leffler model, for example, firm-specific assets such as “luxurious storefronts,” as well
as point-of-sale investments, can supply information that the firm is
advertising, and therefore supply information about the opportunity costs to firms of “cheating” and producing low quality goods
or services.105 Contrary to the assumption that brand-name investments and so-called “non-informative” advertising are not valuable,
consumers that are willing to pay a higher price for brand name
items are rationally purchasing additional quality assurance because firms selling brand-name products have more to lose by failing to provide quality goods or services.106 In the supermarket con-
Benjamin Klein & Keith B. Leffler, The Role of Market Forces in Assuring Contractual
Performance, 89 J. POL. ECON. 615, 629-33 (1981). The “complementary” view of advertising, wherein individuals have stable preferences and consumption of advertising
is complementary to consumption of the good, also considers the possibility that
consumers value advertising without information. See, e.g., George J. Stigler & Gary
S. Becker, De Gustibus Non Est Disputandam, 67, 83-87 AM. ECON. REV. 76 (1977); Gary
S. Becker & Kevin M. Murphy, A Simple Theory of Advertising as a Good or Bad, 108 Q.
J. ECON. 941 (1993).
105 Klein & Leffler, supra note 104, at 630-31.
106 The idea that reputations and brand names may facilitate private contract enforcement has a long history in economic thought. See, e.g., FRIEDRICH A HAYEK, Stafford Little Lecture at Princeton University: THE MEANING OF COMPETITION (May 20,
1946), IN INDIVIDUALISM AND ECONOMIC ORDER 92, 97 (1948); ALFRED MARSHALL,
PRINCIPLES OF ECONOMICS: AN INTRODUCTORY VOLUME (1949); Stewart Macaulay,
Non-Contractual Relations in Business: A Preliminary Study, 28 AM. SOC. REV. 55 (1963);
Klein & Leffler, supra note 104. The related idea concept that advertising and brand
name investments may have a quality-guaranteeing effect was also emphasized by
early economic thinkers. See, e.g., Emily Fogg-Meade, The Place of Advertising in Mod104
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509
text, the purchase of premium shelf space and point-of-sale promotional investments may play a role in providing incentives that assure contract performance.107
While I have emphasized the view that empiricism will ultimately resolve the extent to which behavioral insights should be
incorporated into economic analysis of law, at least in the relatively
data-rich environment of consumer contracts, the shelf space example suggests that there are at least some limits to this relatively optimistic view. The implication of the fact that some supermarket
consumers value premium shelf space signals for consumer irrationality is, at least partially, a matter for interpretation. That interpretation must be guided by alternative theories explaining the
data. I have suggested in the case of shelf space contracts and supermarket advertising, and consistent with the broader set of consumer contracts that are the subject of this essay, that neoclassical
price-theoretic models have greater explanatory power.
V. Conclusions
The message of this essay has primarily been that in the
sample of consumer contracts examined here—credit card contracts,
standard form contracts more generally, and supermarket shelf
space allocation—behavioral economic analysis, despite claims to
the contrary in the legal literature, has not provided greater predictive power than its neoclassical counterpart. The limits of this survey are obvious, and the findings in these particular settings only
begin to shed light on the more critical question of what explana-
ern Business, 9 J. POL. ECON. 218, 234 (1901); ALFRED MARSHALL, INDUSTRY AND
TRADE: A STUDY OF INDUSTRIAL TECHNIQUE AND BUSINESS ORGANIZATION; AND OF
THEIR INFLUENCES ON THE CONDITIONS OF VARIOUS CLASSES AND NATIONS 300-02
(1919). Klein & Leffler, supra note 104, present an early formalization of the role of
advertising in assuring the supply of quality. For a comprehensive survey of the
economics of advertising, see Kyle Bagwell, The Economic Analysis of Advertising (unpublished
working
paper,
Aug.
2005),
available
at
http://www.columbia.edu/~kwb8/adchapterPost082605.pdf.
107 Wright, supra note 95, analyzes the role of category management in retail distribution in facilitating contract performance.
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tory power behavioral insights have added in other contexts. Nor
do the results here suggest that irrational behavior does not cause
significant inefficiencies in some markets, or that intervention will
never be required to minimize those inefficiencies. Incorporating
the insights of behavioral economics will doubtlessly add explanatory power to existing approaches in some areas. For example, there
is burgeoning literature in industrial organization economics 108
which discusses the implications of bounded rationality and “psychology and economics,” and which may ultimately improve our
understanding of markets.
The evidence of firm and consumer behavior within this
subset of contracts, however, minimally suggests that legal scholars
approach cautiously the very common practice of relying on experimental evidence as the foundation for advocating paternalistic
interventions in consumer markets on the assumption that the findings in these experiments translate to markets. Unfortunately, the
explosion of paternalistic proposals within the behavioral law and
economics literature do not always display such caution. Klick and
Mitchell describe the behavioral law and economics literature as
generally “proceed[ing] from little more than an identification of a
cognitive bias that may explain a patter of seemingly inefficient
choices,”109 and offer a set of factors emphasizing both the dynamic
consequences of paternalistic intervention as well as the relative
institutional costs and benefits of public versus private decisionmaking, that should inform institutional design decisions aimed at
correcting inefficiencies caused by systematic irrationality.110 Careful efforts by legal scholars to address the cost-benefit analysis con-
108 See, e.g., Glenn Ellison, Bounded Rationality in Industrial Organization (unpublished
paper,
Aug.
2005).,
available
at
http://www.hss.caltech.edu/~camerer/NYU/05-Ellison.pdf.
109 Klick & Mitchell, supra note 5, at 1654.
110 Id. at 1653-61. See also Glaeser, supra note 5, at 133-34, 146-49 (comparing the relative costs of government and individual decision-making, considering models where
endogenous cognitive error increases the advantage of private decisionmaking, and
arguing that the presence of cognitive error should “make us more, not less, wary
about trusting government decisionmaking”).
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511
templated by these factors, rather than merely assuming that paternalistic regulations will increase welfare where individuals exhibit
some cognitive bias in experimental settings, along with subjecting
both behavioral and neoclassical economic models to continued
empirical testing in the field and in markets, should serve to improve the quality of debate as to whether, when, and what types of
paternalistic intervention are justified.